The "Smart" Money

Read: The smart money was on the sideline while the market went up 4%.

Of course, they are still collecting their "2 & 20" fees
- The 2% management fee gets charged whether the fund gains or loses money
- Plus a 20% performance fee on the gains (when they exist)

What are hedge funds again? Expensive, loosely regulated investment funds with a single objective: make money in the public markets by betting for or against securities. And with enough leverage to, from time to time, blow up.

Don't get me wrong, I'm perfectly fine with rich people throwing their money away.

So why am I writing about this?

Because these funds are becoming more available to my clients and to everyday investors. Technically to accredited investors: income above $200,000 or net worth above $1 million. They are also showing up in the pension funds many of us have through employers and public retirement systems.

Here is why I don't believe they make sense:

Expensive: as noted above. Cliff Asness said it best: "There's no investing strategy so good that a high fee can't make it bad."
Taxes: gains are distributed annually. When a fund buys and sells frequently, more of those gains are taxed at short-term rates (up to 37%) rather than preferential long-term capital gains rates (up to 20%).
Scale: there are diseconomies of scale in investing. Once a fund does well, everyone wants in, and deploying that much capital effectively gets harder.
Exclusivity: because of the scale problem, many funds close to new investors. Others go private altogether and manage only their now-wealthy managers' money.
Minimums: the ones that stay open often demand very high minimum investments, along with lock-up periods where you cannot withdraw your money.

In 2007, Warren Buffett bet $1 million that an S&P 500 index fund would beat a basket of hedge funds over ten years. One firm finally took him up on it. Over the ten years, the index fund compounded at roughly 8.5% a year. The hedge funds managed about 2.2%, and their manager conceded before the decade was up.

There was a famous advisor serving ultra-high-net-worth clients who, when asked what he does for them, said: "I keep them out of the hedge funds and private deals pitched at their country club."

For what it's worth, I am against venture capital and private equity for many of the same reasons. Most of the companies worth owning will eventually go public, at which point we will own those too. If price transparency, fees, and access are ever democratized enough that we can add them in a low-cost, diversified way, we will.

In the meantime we will have to make do with the 13,464 public companies across the globe our typical client holds in their portfolio.

Until next time, stay the course.